How the California Earthquake Authority finds value in catastrophe bonds

28th October 2011 - Author: Artemis

The Embarcadero Re earthquake catastrophe bond transaction issued by the California Earthquake Authority (CEA) back in August was hailed as a ground-breaking cat bond transaction for a number of reasons. We’ve spoken with the CEA to get some insight into why they utilised a cat bond and where this adds value for them. The cat bond allowed the CEA to bypass traditional reinsurers, achieve a greater level of diversification in their sources of cover and secured them $150m of cover at cheaper rates than traditional reinsurance could. As a result the CEA is likely to return to the cat bond market on a regular basis as and when the conditions are right to build the capital markets cover they have. This first-of-its-kind transaction opens a more direct path for the CEA to transfer the financial risk posed by earthquakes.

The transaction allows CEA to obtain reinsurance from the capital markets rather than solely from reinsurers. The initial $150 million, three-year deal – the first earthquake-only catastrophe bond issued without involvement of traditional reinsurers – is intended to be a benchmark establishing a more efficient, lower-cost market for similar follow-on deals by CEA, while expanding the sources and amount of claim-paying capacity available to the CEA.

“This deal is a game-changer,” said CEA Chief Executive Officer Glenn Pomeroy. “Traditional reinsurance has been valuable for the CEA, and will be going forward. But the CEA must diversify and expand its claim‐paying resources. A diverse set of risk-transfer tools, which includes not only reinsurance and catastrophe bonds but also post-earthquake federal loan guarantees, will help us make earthquake insurance more affordable and more widely used.”

“The costs of natural disasters today fall largely on the federal government,” Pomeroy added. “But every household that is able to buy CEA earthquake insurance is a household that will depend less on federal aid in the aftermath of a big earthquake.”

The CEA is the largest monoline writer of residential earthquake insurance in the United States. With over 800,000 policies in force, some $600 million in annual premium revenue, and more than $9 billion in overall claim-paying capacity, the CEA writes 70 percent of all residential earthquake policies sold in California. Yet according to the data, fewer than 12% of California households choose to buy earthquake insurance.

The CEA relies heavily on reinsurance, which provides $3.1 billion out of the CEA’s $9.4 billion claims-paying capability. While reinsurance is appropriate to help CEA manage financial risks of insuring against earthquakes, it comes at a high cost. During the past 14 years, CEA has paid $2.8 billion to reinsurers, more than 40 percent of its $6 billion total premium revenue.

Under the new “transformer reinsurance” deal, the CEA entered into a reinsurance contract with Embarcadero Reinsurance, Ltd., a Bermuda-based special purpose reinsurance vehicle established for this and future CEA transactions. In a deal led by Deutsche Bank Securities, Embarcadero sold $150 million in three-year catastrophe bonds to investors, at a floating rate of 6.6 percentage points above one-year U.S. Treasury money-market funds. Investor demand for the catastrophe bonds significantly exceeded the $150 million issuance. The $150 million in deal proceeds was placed in a collateral trust account, from which the CEA can draw funds if necessary to fund its actual insured losses and loss-related expenses covered by the reinsurance contract.

“This deal establishes a multi-year, repeatable method of risk transfer that’s less costly than traditional reinsurance,” said CEA’s Chief Financial Officer Tim Richison. “We intend to be back in the marketplace every four to six months and will continue to do so as long as there is interest from investors. Using the same structure in future transactions will make it easier for investors to understand and be comfortable with the terms, and will build the investor base to increase market capacity for follow-on deals.”

One unique feature of the CEA’s Embarcadero deal is that it provides total indemnity for CEA’s actual reinsured losses and claim expenses covered by the contract. Supposed indemnity deals often leave deal beneficiaries with substantial residual basis risk. Under the Embarcadero Re contract, CEA expects to retain zero basis risk, thus effecting a perfect risk match between its exposures and the reinsured losses.

We asked the CEA when they would next attempt to issue a cat bond through Embarcadero Re and they replied saying that they expect to add to their transformer reinsurance protection early in Q1 2012 and then again in Q2, sticking to their schedule of issuing every 4 to 6 months. This is likely to be kept up as they transfer more of their traditional reinsurance cover to cat bonds over time until they feel they have achieved a good balance in the reinsurance portfolio.